Hot Money bringing down U.S. banks -- and Iceland


Banks that are not deemed too big to fail are failing fast -- the FDIC has overseen 52 failures so far this year. And one of the biggest causes of these failures is what's called Hot Money -- high rate deposits gathered by brokers from around the country (if not the world). The 79 U.S. bank failures in the last two years had four times the brokered deposits of the average bank, and 33 percent of the failed banks had high brokered deposits and extremely fast growth.

Why does Hot Money cause bank failures? Those deposits pay rates of return that are around 20 percent higher than the average so huge amounts of money flow to the highest paying banks -- and when those banks get in trouble and can't keep up, the money flows out of them just as fast. But the rapid growth in deposits leads banks to apply Say's Law, the economic notion that supply creates its own demand.

For banks, the new supply of deposits, creates big demand to lend it out. How so? If a bank pays deposit rates of 5.25 percent, it is going to lose money unless it can make loans at an even higher rate. So the influx of Hot Money forces lenders to make lots of risky loans on which it can charge higher rates. Security Bank (SBKC), near Atlanta, boosted its brokered deposits from $693,000 in 2000 to $798 million in 2008 -- paying 5.28 percent interest, or 20 percent higher than what local banks paid their customers.